Margin of Safety (MOS):

Contents:

The
excess of actual or budgeted sales over the break
even volume of sales is called margin of safety.
At break even point costs are equal to sales revenue
and profit is zero. Margin of safety, therefore,
tells us the amount of sales that can be dropped
before losses begin to be incurred. With a high
margin of safety business have low risk of not
breaking even and with a low margin of safety
business have high risk of not breaking even.

The formula or
equation for the calculation of margin of safety is
as follows:

Margin of Safety = Total budgeted or actual sales −
Break even sales

Margin of Safety Ratio:

The
margin of safety can also be expressed in percentage
form (Margin of safety ratio). This
percentage is obtained by dividing the margin of
safety in dollar terms by total sales. Following
equation is used for this purpose.

Margin of Safety = Margin of safety in dollars /
Total budgeted or actual sales

Calculation:

Sales(400units
@$250)

$100,000

Break even
sales

$ 87,500

Margin of
safety in dollars

$ 12,500

Margin of
safety as a percentage of sales:

12,500 /
100,000

= 12.5%

It
means that at the current level of sales and with
the company's current prices and cost structure, a
reduction in sales of $12,500, or 12.5%, would
result in just breaking even. In a single product
firm, the margin of safety can also be expressed in
terms of the number of units sold by dividing the
margin of safety in dollars by the selling price per
unit. In this case, the margin of safety is 50 units
($12,500 ÷ $ 250 units = 50 units).

Case Study (A Real
Business Example):

Pak Melwani
and Kumar Hathiramani, former silk merchants
from Bombay, opened a soup store in
Manhattan after watching a Seinfeld episode
featuring the "soup Nazi." The episode
parodied a real life soup vendor. Ali
Yeganeh, whose loyal customers put up with
hour-long lines and "snarling customer
service." Melwani and Hathiramani approached
Yeganeh about turning his soup kitchen into
a chain, but they were gruffly rebuffed.
Instead of giving up, the two hired a French
chef with a repertoire of 500 soups and
opened a store called Soup Nutsy. For $6 per
serving, Soup Nutsy offers 12 homemade soups
each day, such as sherry crab bisque and
Thai coconut shrimp. Melwani and Hathiramani
report that in their first year of
operation, they netted $210,000 on sales of
$700,000. They report that it costs about $2
per serving to make the soup. So their
variable expenses ratio is one-third ($2
cost / 6$ selling price). If so, what are
their fixed expenses? We can answer that
question using the equation approach as
follows:

Sales =
Variable expenses + Fixed expenses + Profits

$700,000 =
(1/3) × 700,000 + Fixed expenses + $210,000

Fixed expenses
= $700,000 – (1/3 of $700,000) – $210,000

= $256,667

With this
information we can determine that the break
even point is about $385,000 of sales. This
gives the store a comfortable margin of
safety of 45%.